The US government believes that tax cuts will be self-funding. The evidence does not support this

In the National Museum of American History, there is an exhibit of a white cloth napkin taken from a Washington DC restaurant in 1974. The reason it is there because it is adorned with a graph and some scribbling that came to have a profound effect on economic thinking. The diners were Dick Cheney, Donald Rumsfeld, Jude Wanniski, and a 34-year-old economist called Art Laffer who gave his name to the curve on the graph, the Laffer curve. It was the core thinking behind the economic policies of Ronald Reagan, both George Bushes, and now President Donald Trump. The Laffer Curve basically says that significant cuts in taxation are self-financing because of the galvanising effect on economic growth and jobs. Discuss.

Let us just remember that Laffer’s reasoning was used to justify Reagan’s tax cuts in the early 1980s. In the event, Reagan tripled the Federal deficit from 2 to 6 per cent instead of balancing the budget in four years as he had promised, and added more to the stock of Federal debt than all the Presidents from George Washington to Jimmy Carter combined. He tripled debt outstanding from $900bn to $2.7trn. The debt to GDP ratio had tumbled from 117.5 per cent in 1945 to 32.5 per cent when Reagan took office. By the time George H Bush left office in 1993, it had doubled to 66 per cent. Under Bill Clinton, it dropped back to 56.4 per cent, but George W Bush, pursuing similar fiscal policies to his father and to Reagan, pushed the ratio back up to 73 per cent. It is true that President Barack Obama left office with debt to GDP at around 100 per cent but remember this includes a pile of debt owned by the Federal Reserve not the public, and is attributable mainly to the financial crisis and what followed, not a belief in self-financing tax cuts.

In any event, these empirical observations seem not to be enough for modern day Laffer fans.

Last Wednesday, the Trump Administration released one sheet of paper, rather than a full document that calls for a dramatic overhaul of the US tax code. The government wants, amongst other things, to replace seven income tax rates with three (10, 25 and 35 per cent), increase tax-free income allowances, cut corporation tax from 35 to 15 per cent, introduce a one-time tax holiday or relief for corporations to bring home “trillions of dollars” held overseas, and abolish the so-called Alternative Minimum Tax (AMT) and the estate tax.

Politically, these measures will be contentious because, by and large, they favour better off households and companies. The exact tax brackets haven’t been decided but anyone earning over roughly $400,000 a year will get a proportionately large tax cut. The AMT and estate tax abolitions would also benefit the better off. Estate tax is only levied on estates above $5.49m anyway. It isn’t clear what the corporate tax rate cut will do because according to a 2016 Government Accounting Office study, large companies on average paid tax at 14 per cent, and two-fifths of companies paid no tax at all between 2008-2012. Further, while it’s worthgetting US firms to bring home earnings held overseas, there’s no guarantee they will use the funds to create jobs or spend on investment. They could simply leave the cash idle in the US or pay higher dividends.

Economically, the tax plan will be no less contentious. The government presented no data on the possible effects on Federal revenues and Federal debt. Treasury Secretary Steve Mnuchin and White House chief economic adviser Gary Cohn did say they might propose an elimination of tax deductions other than for mortgage interest, retirement savings and charitable giving, but otherwise the mantra in government and in parts of the Republican Party is to repeat the Laffer assertion that much faster economic growth will pay for the tax plan. Other parts of the Republican Party, comprising deficit hawks and small government supporters, may prove much harder to persuade. They may actually not support unfunded tax cuts and demand draconian cuts in Federal spending as a quid pro quo.

As far as the self-financing tax cut goes, independent analysis says this was and remains, to borrow from Macbeth, the fiscal equivalent of eye of newt and toe of frog. The independent Committee for a Responsible Federal Budget has argued that adding in cumulative interest costs, the Trump tax plan would result in a $5.5trn loss in tax revenues over 10 years (range $3-7trn), and cause the ratio of debt held by the public to rise from 77 per cent of GDP to 111 per cent by 2027. It is going to rise anyway under current tax and spending laws because of rising healthcare expenditure especially, but the tax plan would push it materially higher. They make a poignant case that there isn’t an achievable rate of economic growth that can finance the proposed changes in the tax code, and that the US would need to realise 4.5 per cent annual growth to pay for the plan. This is 2.5 times the Congressional Budget Office’s estimate of potential economic growth and equivalent to the kind of growth the US last had in the 1960s and early 1970s under radically different circumstances. In fact, the situation could be even worse: if higher deficits result in higher interest rates and higher debt that act as a drag on growth, then the rising deficits and debt and weaker growth will become locked in a vicious circle.

Trump’s tax plan may, like the proposed repeal of Obamacare, end up going nowhere because of a lack of consensus on Capitol Hill. Not all the tax proposals are bad, and some overhaul and simplification of the tax code, including the end of some tax reliefs, is justified. The US economy might get a short-term boost if the plan passes. But what the Laffer curve has taught us is that funded tax cuts are more effective in shaping the economy than unfunded tax cuts, and that the latter simply end up causing higher fiscal deficits and economic trouble.

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Comments

Clarke P.

May 5, 2017 at 09:41

Could it be that prescription is right but the tax rates and thresholds have been set at too low a level? If corporate tax was 20% and the income tax was set at 10%, 30%, and for very high incomes 50% then the numbers might stack up rather better.
Your scepticism about the impact of repatriated corporate profits seems at odds with conventional thinking. Having cash trapped in offshore tax havens holding for the most part low yielding government debt can not be an efficient use for such large sums. Even if the companies distribute as dividends it is likely to find a more productive home fairly quickly.

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